The tax treatment of an
insolvent debtor realizing discharge of
indebtedness income under the U.S.
consolidated income tax return rules can
vary considerably depending on the
particular circumstances. As discussed
below, the consolidated tax rules
governing transactions involving
intercompany debt obligations between
members of the same consolidated group
differ greatly from the rules that govern
debt obligations owed by an insolvent
debtor/member to a nonmember creditor. The
application of these rules presents
numerous tricks and traps for the
unwary.

This item highlights the U.S.
consolidated tax return rules that govern
the treatment of cancellation of
indebtedness (COD) income (see generally
Regs. Secs. 1.1502-13(g) and -28). A
comprehensive discussion of these rules is
beyond the scope of this item.
Accordingly, if a member of a consolidated
group realizes COD income, taxpayers and
practitioners are urged to thoroughly
familiarize themselves with these rules to
ensure that all relevant issues are
identified and properly addressed.

Sec. 108 Gross Income
Exclusion and Attribute Reduction
Rules

COD is an item of gross income
that is subject to current taxation under
Sec. 61(a)(12), unless it is otherwise
excluded. For example, COD income is
excluded from current taxation if the COD
event occurs in a Title 11 bankruptcy
case, i.e., where the debtor/taxpayer is
under the jurisdiction of the bankruptcy
court. COD income is also excluded from
current taxation if the taxpayer is
insolvent. Sec. 108(d)(3) provides that a
taxpayer is considered insolvent if its
liabilities exceed the fair market value
(FMV) of its assets immediately before the
COD event occurs.

If COD income is
excluded under the insolvency exception
rules, the debtor/member is required to
reduce certain specified tax attributes
and asset bases in accordance with the
ordering rules set forth in Secs. 108(b)
and 1017. As is further discussed below,
the application of these rules can have
anomalous consequences.

Sec. 108 also contains a number of
other rules that can either eliminate or
reduce the amount of realized COD
income. Of particular relevance here are
the contribution-to-capital and
stock-for-debt rules.

The
following discussion assumes that the
insolvent member does not
elect under Sec. 108(b)(5) to apply
attribute reduction first against
depreciable property and does not elect to
treat the stock of lower-tier members as
depreciable property pursuant to Sec.
1017(b)(3)(D).

Shareholder Capital
Contribution of Debt

Under the
Sec. 108(e)(6) contribution-to-capital
rule, if a corporation acquires its debt
from a shareholder, the transferee
corporation is treated as satisfying the
debt with an amount of money equal to the
shareholder’s basis in the debt. Two
examples illustrate the application of
this rule.

Example
1:A Co.,
an accrual-method debtor/corporation,
accrues an unpaid expense owed to B, a
cash-method creditor/shareholder. B has
not recognized income yet and therefore
has no basis in the obligation. If B later
contributes her zero-basis liability to
A Co.,
the corporation recognizes COD income to
the extent of the face amount of the
liability.

Example
2: On the other hand, if B loans
money to A Co.
and B’s
basis in the debt is equal to the face
amount of the debt, A Co.
does not realize COD income on B’s
contribution of the debt because B’s
basis in the debt is equal to the face
amount.

On the surface, this rule appears
straightforward. However, to fall within
the scope of Sec. 108(e)(6), the
creditor/shareholder’s transfer of the
debt to the debtor/corporation must be
respected as a capital contribution. The
following IRS memoranda illustrate
situations where a debt discharge was
not deemed to constitute a capital
contribution.

In TAM
200101001, a subsidiary corporation’s debt
owed to its parent corporation was
discharged in connection with a bankruptcy
proceeding. The IRS ruled that the parent
did not make a capital contribution to the
subsidiary because (i) the debt was not
voluntarily canceled, (ii) the debt was
canceled at the same rate as the other
creditors, and (iii) the subsidiary did
not issue any additional stock to the
parent. In FSA 199915005, the IRS ruled
that a parent’s cancellation of subsidiary
debt did not constitute a capital
contribution to the extent the subsidiary
remained insolvent after the
cancellation.

By contrast, in Lidgerwood
Mfg. Co.,229
F.2d 241 (2d Cir. 1956), aff’g 22 T.C.
1152 (1954), the Second Circuit held that
even if a debtor/subsidiary was insolvent
both before and after a creditor/parent’s
debt cancellation, the cancellation was a
valuable contribution to the financial
position of the subsidiary because it
enabled the subsidiary to continue in
business. See also FSA 1997 FSA LEXIS 636
(Lidgerwood
followed). The capital contribution issue
is more fully discussed in several
treatises (see, e.g., Henderson and
Goldring, Tax Planning
for Troubled Corporations, ¶505
(CCH 2011); and Garlock, Federal
Income Taxation of Debt
Instruments, ¶1603.04[B] (CCH
2011)).

The capital contribution
stakes can be quite considerable. If the
debt transfer is respected as a capital
contribution, the debtor/corporation may
realize little, if any, COD income.
Consequently, the amount of Sec. 108(b)
attribute reduction would be minimal (if
at all). By contrast, if the transfer is
not
respected as a capital contribution, the
debtor/corporation would likely realize
COD income to the extent of the face
amount of the debt (including accrued
interest). This could result in a
significant amount of Sec. 108(b)
attribute reduction.

Issuance of Stock to Satisfy
Corporate Debt

The Sec. 108(e)(8)
“stock-for-debt” rule provides that if a
debtor/corporation issues its stock in
satisfaction of a debt obligation, COD
income is realized to the extent that the
face amount of the debt exceeds the FMV of
the stock. If there is only one
creditor/shareholder, there is a question
of whether the contribution-to-capital
rule or the stock-for-debt rule applies
where the debtor/corporation does not
issue stock. In such cases, the issuance
of stock would be a meaningless
gesture.

In Lessinger,
85 T.C. 824 (1985), aff’d in relevant
part, 872 F.2d 519 (2d Cir. 1989), the Tax
Court held that the Sec. 351 stock
issuance requirement was satisfied when a
shareholder transferred assets to his
wholly owned transferee corporation even
though stock was not
issued. The court reasoned that the
issuance of stock would have been a
meaningless gesture because the
shareholder’s ownership percentage in the
transferee corporation would not have
changed. Nevertheless, for COD purposes,
the IRS has issued a number of letter
rulings that generally respect the form
adopted by the taxpayer (see Henderson and
Goldring, ¶505 at p. 168, nn. 12 and
13.)

Treatment of
Intercompany Debt Under the Consolidated
Tax Return Rules

As explained in
Regs. Secs. 1.1502-13(a)(2) and (a)(6),
the consolidated tax return rules try to
achieve single-entity treatment with
respect to intercompany transactions. For
this purpose, intercompany obligations
between members are governed by the
intercompany transaction rules (see
generally Regs. Sec. 1.1502-13(g)). For
example, in Regs. Sec.
1.1502-13(g)(7)(ii), Example (1), interest
payments made on an intercompany loan are
treated as interest income to the lender
and interest expense to the borrower on a
separate company basis. Nevertheless,
consolidated taxable income is not
affected because the two amounts offset.
Accrued original issue discount (OID) on
intercompany loans is treated as
interest.

The intercompany
transaction regulations achieve similar
results in other applications involving
intercompany debt. For example, if a
creditor/member claims a partial bad debt
deduction under Sec. 166(a)(2) or sells an
intercompany loan to another member for an
FMV amount that is less than the face
amount, the intercompany regulations
achieve single-entity treatment on a
consolidated basis in the following
ways:

First, Sec. 108 is “turned off”
under Regs. Sec. 1.1502-13(g)(4)(i)(C).
So, even if the borrower is insolvent, COD
income would not be
excluded from the debtor/member’s separate
company income. Hence, there is no
attribute reduction under Sec. 108(b).

Second, regardless of whether the
creditor/member claims a partial bad debt
deduction or sells the loan to another
member, the regulations apply a deemed
satisfaction and deemed reissuance rule.
Thus, under Regs. Sec. 1.1502-13(g)(3),
the debtor/member is deemed to satisfy the
loan at FMV and then reissue the debt to
the creditor/member. Assuming the FMV of
the loan is less than face value, the
debtor/member, regardless of solvency,
recognizes COD income on a separate
company basis. Moreover, because Sec. 108
does not apply, there is no attribute
reduction under Sec. 108(b). The “newly
reissued” loan is an OID instrument
because the face amount will be greater
than the new issue price.

In the case of an intercompany sale,
the original creditor/member recognizes
a capital loss under Sec. 1271 on a
separate company basis because the
debtor/member is deemed to have
satisfied the note at an FMV amount less
than face immediately before the sale.
However, to achieve matching under the
single-entity approach, the
creditor/member’s capital loss is
recharacterized as an ordinary loss.
Thus, the character of the loss is the
same as that of the creditor/member that
claims a partial bad debt deduction under Sec. 166(a)(2).

In either case, the net
result is the same. The debtor/member
recognizes ordinary COD income, and the
creditor/member recognizes an offsetting
ordinary loss or deduction of matching
character. Hence, consolidated taxable
income is not affected. Regs. Sec.
1.1502-13(g)(7)(ii), Example (3),
illustrates these rules.

Lastly,
pursuant to Regs. Secs.
1.1502-13(g)(3)(i)(B) and (g)(3)(i)(B)(5),
the deemed satisfaction and deemed
reissuance rule does not
apply where an intercompany obligation is
extinguished (e.g., as a contribution to
capital) provided that the
creditor/member’s adjusted issue price of
the debt (generally the face amount) is
equal to the debtor/member’s basis.
Otherwise, as provided in Regs. Sec.
1.1502-13(g)(3)(ii)(A), the deemed
satisfaction and deemed reissuance rule
applies, and the group needs to take into
account the resulting tax
consequences.

Treatment
of Debt Owed to a Nonmember Under the
Consolidated Tax Return Rules

In
contrast to the single-entity approach
taken under the consolidated intercompany
transaction rules, Regs. Sec. 1.1502-28(a)
generally applies a separate company
approach when an insolvent
debtor/member realizes COD income in cases
where the insolvent debtor/member owes
money to a nonmember. Under the separate
company approach, insolvency is measured
on a separate company basis taking into
account only the assets and liabilities of
the insolventmember. Notably, the insolvent
member’s assets include stock and
securities of other members, and its
liabilities include debts owed to other
members.

Regs. Secs. 1.1502-28(a)(2) through
(4) provide a multistep approach with
respect to applying the Secs. 108(b) and
1017 attribute reduction rules. The
first step contemplates that attribute
reduction is applied to the insolvent
member that recognized the COD income
with respect to that member’s separate
company attributes. Secs. 108(b)(2) and
Regs. Sec. 1.1017-1(a) prescribe the
specific order in which the insolvent
member’s attributes are reduced.

It should be noted that Regs.
Sec. 1.1017-1(a) provides that attribute
reduction of the member’s property occurs
as of the first day of the tax year
following the COD event. In addition,
Regs. Sec. 1.1017-1(b)(3) limits the
amount of basis reduction to the aggregate
bases of the insolvent member’s property
over the aggregate amount of liabilities
immediately after the COD event—again, as
determined on a separate company
basis.

As alluded to above, the
application of the attribute reduction
rules may pose a potential trap. If
attribute reduction is applied to reduce
the basis of the intercompany loan
receivable, there is an asymmetry between
the insolvent member’s basis in the loan
and the face amount owed to the other
member. As explained above, if at a later
time a deemed satisfaction and deemed
reissuance triggering event occurs,
separate company gain and loss may not
offset when computing consolidated taxable
income. Regs. Sec. 1.1502-28(b)(5)(ii)
appears to contemplate this possibility.
It may be possible to ameliorate this
issue through advance planning.

The
next step applies a lookthrough approach
with respect to lower-tier members. If the
basis of a lower-tier member’s stock is
reduced, the lower-tier member is treated
as realizing COD income on the last day of
the tax year during which the actual COD
event occurs. Attribute reduction as
prescribed by Secs. 108(b) and 1017 is
applied as described above (including the
limitation on the reduction of basis).

The regulations touch on another
potential trap relating to Sec. 1245
taint. Regs. Sec. 1.1502-28(b)(4) provides
that the reduction of basis in a
lower-tier member’s stock is treated as a
depreciation deduction to the extent that
the amount of the reduction exceeds the
amount of the member’s attributes that are
reduced under the lookthrough rule. This
excess amount could be subject to Sec.
1245 recapture upon the later occurrence
of certain triggering events.

For
example, if, under the tax-free
liquidation rules of Secs. 332 and 337,
the lower-tier member distributes its
assets in liquidation to its immediate
parent, the lower-tier member’s stock
basis disappears. This could trigger
immediate income recognition of the Sec.
1245 taint notwithstanding the application
of Secs. 332 and 337. Similarly, if the
stock of the lower-tier member is later
sold to an unrelated corporation and the
parties make a joint Sec. 338(h)(10)
deemed asset sale election, the deemed
Sec. 332 liquidation of the target
lower-tier member could also be a
triggering event. In the more ordinary
case, if the group sells the stock of the
lower-tier member whose stock is
“tainted,” any gain recognized could be
characterized as ordinary income rather
than capital gain income to the extent of
the Sec. 1245 taint.

Conclusion

The
consolidated tax return rules that govern
the treatment of member debt owed to other
members of the same consolidated group and
member debt owed to nonmember creditors
are extremely complicated. Taxpayers and
their advisers should be diligent in
understanding how these rules operate in
order to avoid pitfalls and traps.

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